Performance Measurement

(Evaluation Systems)
 Performance Measurement
 Performance measurement systems are an
integral part of the management control systems
 Management control is a process through which
management ensures that resources are obtained
and used effectively and efficiently in
accomplishing the organization's goals
 To be most effective performance measures
should be tied to the strategic objectives of the
organization
 Two key principles of performance measurement
 Measurement of performance
 Compensation based on measured performance
Performance Measurement:
Theories of Incentives and Behavior
Expectancy theory (from
applied psychology)
 People are motivated to act
in ways that they expect to
provide them with desired
rewards and to prevent the
penalties they wish to avoid.
 So incentive plans must:
◦ Provide the proper rewards
and penalties
◦ Make it likely that the
desired behaviors will lead
to those rewards or
penalties
Agency theory (from financial
economics)
 An employee contracts with
an employer to perform
certain work, and the
employer wants to be sure
that the work is duly and well
performed.
 So incentive plans must:
◦ Motivate the employee to
work
◦ Align the employee’s goals
with the employer’s
Effective Performance Measurement
System
Theory and Practice
Most individuals are motivated by
self-interest.
Organizations get the behavior they
reward.
Effort follows rewards.
Difficult but attainable goals
motivate best.
Fairness is a basis for sustained
motivation.
Manipulation undermines fairness
and effort.
Different rewards can motivate
effort.
Incentive systems involve trade-offs. Minimizing the overall costs of
Guideline
Performance-based rewards must
be greater than alternative rewards
from nonperformance.
Performance measures and related
rewards must reflect organizational
goals.
Employees must believe that their
efforts influence performance.
Impossible goals are de-motivators,
and so are easy goals. Make goals
difficult but not impossible.
Rewards must be linked to desired
performance in a fair manner.
Performance measures must be
observable and verifiable.
Rewards must meet market
conditions, and rewards must be
available.
aligning goals and monitoring
behavior is a goal of incentive
system design.
Uses of Performance Measurement

 1) Monitoring
 2) Decision Making
 3) Attention Focus
 4) Legitimization
 5) Compensation – income is not guaranteed

but dependent on performance

 6) Translating and implementing strategy
Dysfunctional Outcomes of Performance
Measurement

 Fundamentals problems exist in performance

measurement if the unintended behavior is
created
 Designers of incentive plan can be surprised
to find that these systems create unintended
behavior
 Examples:
◦ Credit Lending– performance measurement was $$
$ of credit extended
◦ Enron – performance measured by stock price and
revenue recognition
What makes an
effective
performance
measurement
system?
Effective Performance Measurement
System
 Given the goals of the company which alternative
incentive will motivate the desired behavior?
 Unlikely a single measure or even several measures
will effectively assess performance
 assesses progress toward organizational goals and
objectives - promote intended behavior
 includes critical success factors
 a mix of financial and nonfinancial – multiple measures
 congruent with reward systems – pay performance link
 participatory and easy to understand by employees
 absolute vs relative evaluation
 Various types of compensation (e.g. salary, bonuses,
options)
Effective Performance Measurement
System

◦ feed back provided

◦ Include both short and long term measures
◦ employees in appropriate jobs & appropriate
performance expectations
◦ attainable performance levels
◦ measures are observable (objective vs. subjective)
◦ responsibility and control is considered (overall vs.
divisional)
◦ limit ability to manage/manipulate outcome
measures
What are some traditional
measures of performance?
Traditional Performance Measures

 Some monetary measurement of income is

used by virtually all businesses to assess
performance
 Financial measures do not address issues of
competitive reality
 1) Cash flow
 2) Return on Investment
 3) Residual Income
 4) Economic Value Added
 Why are traditional
performance
measures inadequate?
Problems with Traditional Measures

 1) Overly aggregate
 2) Not Timely
 3) Backward looking
 4) Promote dysfunctional behavior in the
short term.
 5) Not one measure or type of measure can
realistically capture performance.
What are non-traditional
performance measures?
Nonfinancial Performance Measures

 Traditional financial measures are easy to

measure but inadequate
 Non-financial measures are being used

increasingly instead of traditional systems

 Focus on the leading indicators of profit
 Recognition of the time lags between non

financial and financial performance.

Nonfinancial Performance Measures
(cont’d)

 Non financial performance measures create

shareholder wealth
 Non financial measures better predict future
cash flows
 A large scope of nonfinancial performance
measures relate to critical success factors.
 Intellectual capital becoming the basis of
competitive advantage
 What gets measured gets done
 Customer service is an important measure
 Why are nonfinancial
measures not well utilized
in performance
measurement?
Non-Financial Measure - Current Practice

 Susceptible to measurement problems

 Difficult to measure effectively (accuracy,

ambiguity, timeliness)
 Lead-lag relationship